Tutorial 9

Question 1 (Handwritten)
Value Co (Value) operates under the assumptions of Modigliani and Miller. Value
currently has no debt, and its earnings are expected be $200,000 and can range from
a minimum of $100,000 to a maximum of $500,000. Value has 100,000 shares
outstanding and its shares trade at $15 per share.

(a) Howard is Value’s CFO and Howard argues that Value would be better off by
borrowing $900,000 at 10% interest to repurchase Value’s shares at $15. If Value
goes with Howard’s proposal, what is the change in Value’s ROE when Value’s
earnings before interest is $100,000, $200,000, and $500,000 respectively?

(b) Anne owns 10,000 Value shares. Anne argues that it is unnecessary for Value to
borrow money to repurchase debt since she can borrow as well, at the same interest
rate. If Anne wants to have the same ROE outcomes as Howard’s proposal, how
much will Anne need to borrow, and what is the total number of shares that Anne
will own?

(a)
Share Price 15
Num of Shares 100000
Market Cap 1500000

Repurchase amount 900000

Repurchase share num 60000
Num shares after repurchase 40000
Debt to equity 1.5

EBI 100000 200000 500000

EPS 1 2 5
ROE 0.06666667 0.1333333 0.3333333

EBI 100000 200000 500000

Num of Shares 40000 40000 40000
Interest on Debt 90000 90000 90000
EAI 10000 110000 410000
EPS 0.25 2.75 10.25
ROE 0.01666667 0.1833333 0.6833333
Change in ROE -0.05 0.05 0.35

(b)
Anne 1.5
225000
EPS of unlevered firm 1 2 5
EBI for 25,000 shares 25000 50000 125000
Interest on Debt 22500 22500 22500
Earnings 2500 27500 102500
ROE 0.01666667 0.1833333 0.6833333
Question 2 (Handwritten)
Would you necessarily expect companies in the same industry to have similar debt–
equity ratios? Give reasons for your answer.

The main reason for expecting the debt–equity ratio of companies in the same
industry to be similar is that they have similar business risk. However, companies in
the same industry (for example, retailing) also operate with very different debt–equity
ratios, which suggests that factors other than business risk are important in
determining a company’s debt–equity ratio. For example, since cash inflows are often
used to repay debt, a more profitable company is likely to have a lower debt–equity
ratio than other less-profitable companies in the same industry.
Question 3 (Handwritten)
Critically evaluate the following statements:
(a) It is obvious that companies should use as much debt as possible. It is cheaper
than equity and the interest is tax deductible as well.

(b) The probability of financial distress should be negligible for companies with a
low proportion of debt. Therefore, a low proportion of debt should not have
any noticeable effect on the cost of equity.

(a) Superficially, debt appears to be cheaper than equity—that is, kd < ke. However, the
interest cost of debt is only its explicit cost. Borrowing creates financial risk which
causes the cost of equity capital to increase. This increase in the cost of equity is an
implicit cost of debt and MM show that in a perfect capital market, the true cost of
all forms of finance is the same. The fact that companies are allowed a tax deduction
for interest would give debt an advantage if income to investors in both debt and
equity were taxed at the same rate. However, Miller points out that, generally,
personal tax on debt is greater than that on equity. He argued that this differential
could exactly offset the tax deductibility of interest. In Australia, the imputation tax
system is also relevant (see Question 11(a)).
(b) The statement reflects the traditional view of capital structure and confusion
between two separate risks. The first sentence is basically true, but the second sentence does
not follow from the first. While the risk of financial distress may be negligible, any borrowing
creates financial risk, and the MM analysis shows that shareholders will require
compensation for that risk—that is, the cost of equity will increase as shown by their
Proposition 2.
Question 4 (Handwritten)
Josh Inc., an American manufacturer of consumer plastic products, is evaluating its
capital structure. The balance sheet of the company is as follows (in millions):
Assets Liabilities
Fixed Assets 4000 Debt 2500
Current Assets 1000 Equity 2500
In addition, you are provided the following information:

- The debt is in the form of long term bonds, with a coupon rate of 10%. The
bonds are currently rated AA and are selling at a yield of 12%. The market
value of the bonds is 80% of the face value.
- The firm currently has 50 million shares outstanding, and the current market
price is $80 per share. The firm pays a dividend of $4 per share and has a
price/earnings ratio of 10.
- The stock currently has a beta of 1.2. The six-month Treasury bill rate is 8%,
and the market risk premium is 5.5%.
- The tax rate for this firm is 40%.

(a) What is the debt/equity ratio for this firm in book value terms? How about in
market value terms?
(b) What is the debt to capital ratio (or leverage ratio) for this firm in book value
terms? How about in market value terms?
(c) What is the firm's after-tax cost of debt?
(d) What is the firm's cost of equity?
(e) What is the firm's current cost of capital?

(a) Book Value Debt/Equity Ratio = 2500/2500 = 100%

Market Value of Equity = 50 million * $ 80 = $4,000M
Market Value of Debt = .80 * 2500M = $2,000M
Debt/Equity Ratio in market value terms = 2000/4000 = 50.00%

(b) Debt to capital ratio (or leverage ratio) is Debt / (Debt + Equity).
Book Value Debt / (Debt + Equity) = 2500/(2500 + 2500) = 50%
Market Value Debt / (Debt + Equity) = 2000/(2000+4000) = 33.33%

(c) After-tax Cost of Debt = 12% (1-0.4) = 7.20%

(d) Cost of Equity = 8% + 1.2 (5.5%) = 14.60%

(e) Cost of Capital = 14.60% (4000/6000) + 7.20% (2000/6000) = 12.13%

Question 5 (Excel)
Pinder Inc. in the U.S. is examining its capital structure, with the intent of arriving at
an optimal debt ratio. It currently has no debt and has a beta of 1.5. The riskless
interest rate and the market risk premium are is 9% and 5.5%, respectively. Your
research indicates that the debt rating will be as follows at different debt levels:

D/(D+E) Rating Interest rate

0% AAA 10%
10% AA 10.5%
20% A 11%
30% BBB 12%
40% BB 13%
50% B 14%
60% CCC 16%
70% CC 18%
80% C 20%
90% D 25%

The firm currently has 1 million shares outstanding at $20 per share. Assume
corporate tax rate for this firm is 40%.

(a) What is the firm's optimal debt ratio (only consider the above 10 choices from 0%
to 90%). Please use the cost of capital approach in which you need to check how the
cost of debt (using the debt rating above) and the cost of equity (using the equation
for levered beta) would change at each debt ratio.

(b) What is the current market value of the firm? After the firm restructures its
financial structure at the optimal debt level you calculated in (a), what will be the
value of the firm? Assume that the firm’s assets are expected to generate a constant
annual cash flow forever, which will not be affected by financing policy.

𝐷
(a) Compute the levered beta using 𝛽𝐿 = 𝛽𝑈 (1 + (1 − 𝑡𝑒 ) 𝐸 ) and the cost of equity & the
after-tax cost of debt at each debt ratio.

Debt Cost of After-tax Cost

Ratio Beta Equity of Debt WACC
0% 1.5 17.25% 6.00% 17.25%
10% 1.6 17.80% 6.30% 16.65%
 20% 1.73 18.49% 6.60% 16.11%
30% 1.89 19.37% 7.20% 15.72%
40% 2.1 20.55% 7.80% 15.45%
50% 2.4 22.20% 8.40% 15.30% Optimal!
60% 2.85 24.68% 9.60% 15.63%
70% 3.6 28.80% 10.80% 16.20%
80% 5.1 37.05% 12.00% 17.01%
90% 9.6 61.80% 15.00% 19.68%

So, the optimal debt ratio is 50%.

(b)
Current Firm Value (no debt) = $20 * 1m = $20m
Let’s denote the constant annual cash flow by CF.
Current Firm Value (no debt) = CF/ 17.25% = $20m
∴ CF = $20m * 17.25% = $3.45m
Firm value (with 50% debt) = $3.45m / 15.3% = $22.55m